Sunday, September 21, 2008

FROM MERCANTILISM TO MELTDOWN

Engineers calculate that, for a major accident such as an airplane crash to occur, something like 20 things all have to go wrong. The on-going financial meltdown certainly has multiple causes, too. Greed, bad judgment, mismanagement, lack of effective government oversight, and more certainly were involved. But let’s not overlook the subject of my previous posting (“The Arch Enemy of Free Trade,” September 16): good old-fashioned mercantilism.

For many people, that phrase just doesn’t roll off the tongue, and the connection may not be readily apparent. So, here’s a simple step-by-step connection between mercantilist policies and the currency financial meltdown:

1. Mercantilist countries such as Japan and China use a variety of means to ensure that their currencies are traded at exchange rates well below their true market value.

2. The undervalued (read “cheap”) currency serves as a subsidy to all exports from that country: the exporter gets a bonus of extra home market currency for every international sale. At the same time, an undervalued currency imposes a hidden tariff or tax on all imports: the importer must ante up extra amounts of home market currency to pay for goods from abroad. The result is a chronic trade surplus based on artificial advantages maintained by the mercantilist government. In cash terms, the trade surplus results in an equivalent transfer of funds from trading partners to the mercantilist government.

3. At the same time, cheap currencies induce extra investment. Why? The foreign investor gets more local currency for each dollar or euro. That bonus attracts investment that otherwise would be made somewhere else. So, investment flows are just as distorted as trade flows.

4. The trade surplus and the investment surplus are the main elements in the mercantilist’s current account surplus. Year after year, the cumulative surplus grows. Today, China alone probably has close to 2.5 trillion dollars; Japan, more than one trillion dollars.

5. The problem for the “winners” in this lop-sided current account relationship is to find profitable uses for the money. This has become such a burden that some Chinese openly speak of “unwanted dollars.” They restlessly search the globe for higher returns for their hard currency reserves than mere cash (zero return) or US Treasuries (low risk, low return).

6, That helps explain why Chinese and other foreign investors were easy marks for the Wall Street wizards who churned out new ways to “guarantee” higher and higher returns. Fannie Maes, Freddie Macs, syndicated mortgages – debt was piled upon debt in an elaborate Ponzi scheme that also sucked in pension funds, commercial banks and the proverbial little old ladies like my own mother.

7. In effect, mercantilists, oil exporters and Wall Street wizards got in bed with one another and produced … a huge bubble.

The dots are hereby connected. Mercantilism is not the sole cause of the current crisis, of course, but it one that policymakers around the world have chosen to ignore. Left unchecked, modern mercantilist rigs the game, subverting fair competitive, distorting free markets, and flooding financial markets with funds in search of higher returns.

If monetary authorities in so many countries can cooperate as closely as they have this month to try to stem the tide of imminent financial collapse, why can’t they start cooperating to prevent more, possibly greater, damage from occurring in the future? How to get there will be the subject of my next posting.